No mis-selling of complex derivatives to corporates: RBI

MUMBAI: Banks and bond houses have been told by the regulator not to missell complex derivative products to corporates who may be clueless about the hidden risks in such exotic instruments.

The Reserve Bank of India on Friday came out with strict guidelines under which the size of a bank's derivatives book would be linked to its net worth. It would also require banks to keep a close watch on their bloated off balance-sheet business which primarily comprises derivatives that enable corporates, PSUs and even SMEs to take bets on interest rate and currency movements.

In the recent past, RBI had banned exotic derivatives like quantos and leveraged swaps. Now, the regulator has issued guidelines for rupee derivatives. The big sellers of derivatives are foreign banks, primary dealers and some of the large private banks.

According to RBI, market-makers should undertake derivative transactions, particularly users with a sense of responsibility and circumspection that would avoid, among other things, mis-selling. "It is an imperative that market-makers offer derivative products in general, and structured products, in particular, only to those users who understand the nature of the risks inherent in these transactions and further that products being offered are consistent with users' business, financial operations, skill and sophistication, internal policies as well as risk appetite.

According to the central bank, inadequate understanding of the risks and future obligations under the contracts by the users, in the initial stage, may lead to potential disputes and thus cause damage to the reputation of market-makers. Also, market-makers may be exposed to credit risk, if the counterparty fails to meet his financial obligations under the contract.

According to Standard Chartered Bank's MD global corporate sales, Hemant Mishr , the guidelines will ensure a level-playing field and orderly development of the derivative market going forward. The focus on suitability and appropriateness is particularly welcome and will avoid the kind of mis-selling that has happened in countries like Korea.

RBI has asked market-makers to carry out proper due diligence regarding `user appropriateness' and `suitability' of products before offering derivative products to them. According to bankers, the guidelines will now place a strict onus on the senior management of market makers (banks or PDs.) and also clients.

According to the new guidelines, market-makers will have to have a host of documentation while selling their products. However, this could help the market-makers, in case any questions of mis-selling arises.

RBI has added that risk limits should be integrated across all activities and measured against aggregate individual and geographical risks.

These limits should be compatible with the nature of the entity's strategies, risk-measurement systems, and the board's risk tolerance. In order to ensure consistency between limits and business strategies, the board should annually approve limits as part of the overall budget process.